LEGAL TRANSITION IN THE FINANCIAL MARKETS
Law plays a pivotal role in the development of the financial markets. Legislations have the power to penalize the wrong-doers and ensure order in the market. A strong legal system is capable of taking the economy a long way on the path of progress. The purpose of this article is to trace the development of laws regarding the financial sector and how they were the need of the hour in wake of the financial mishaps that came to light in the late 1980s and early 1990s.
Financial markets simply refer to any place where the trade of long term and short term securities takes place. Securities include shares, debentures and bonds.
Financial markets are an extremely important part of any economy. In the past few decades, the Indian financial markets have been a key indicator of the economic health of the nation.
The article will also present the changes in the functioning of the financial markets over the past few decades and determine why this shift was necessary.
The financial market comprises two main segments: the capital market and the money market.
The capital market is the place where long term securities like shares (both equity and preference), debentures and bonds are traded in.
The money market is the place where short term instruments are traded in. These include treasury bills, commercial paper, commercial bills etc.
Owing to the large amount of public money involved, these markets are required to be regulated.
Capital market is mainly regulated by the Securities and Exchange Board of India (hereinafter referred to as SEBI) and money market is mainly regulated by the Reserve Bank of India (hereinafter referred to as RBI).
Both these organizations influence each other’s decisions. Both these organizations were set up under special Acts of the Parliament.
The SEBI was established under the Securities and Exchange Board of India Act, 1992 while the RBI was established under the Reserve Bank of India Act, 1934.
RBI is the apex bank or central bank of India and has been functional since April 1, 1935.
SEBI was initially established in 1988 and was given statutory authority in January 1992 following a series of frauds and scams that uncovered various loopholes in the financial system.
Both the RBI and the SEBI formulate policies and implement rules and regulations that help in the smooth operation of the economy.
The purpose of both the institutions is to protect the interest of the investors by taking stringent measures.
Securities and Exchange Board of India Act was enforced in 1992 after liberalization in 1991. A major initiative under this was the repeal of the Capital Issues (Control) Act, 1947 in May 1992. The purpose of this Act was to allow the government to control the issue of shares by listed companies. After May 1992, the Government allowed the market to allocate its funds to competing sources for better growth. To ensure security of the investors’ money, the SEBI, now a statutory body, acquired the power to issue various guidelines to listed and unlisted companies, marketing intermediaries and stock exchanges, which were compulsory to be complied with. In case of non-compliance, strict punishments were imposed.
The Disclosure and Investor Protection guidelines made it obligatory for the companies to give a full disclosure of material facts to prospective investors. Apart from that, it gave the SEBI the power to inspect the books of accounts of any company randomly or based on reason to believe that unfair trade practices are prevailing in the company. The SEBI now regulated the information companies gave in their prospectus at the time of raising of capital. Earlier, neither the companies, nor the investors understood the importance of disclosure of material facts. Companies simply disclosed what was asked in the Companies Act, 1956. Investors, too, merely bought securities based on the merit or the goodwill of the company. SEBI’s new regulations brought about a shift in the behaviour of the financial markets from merit based to disclosure based. Gradually, investors realized the importance of analysis of material facts before investing in any share. Companies started exercising more caution to refrain from indulging in unfair trade practices as a result of the new rules and regulations that were imposed. They realized that even small inconsistencies in their financial statements could cause serious loss of public confidence.
After 1992, the SEBI also had full authority over the marketing intermediaries or brokers. Investors are not allowed to directly trade in the stock market. This is where the marketing intermediaries assume an important role. They are licenced by the SEBI to trade in securities as directed by the investor. This makes it easier for the Board to regulate and monitor the activities of the stock exchanges and brokers. Brokers are basically agents in the financial market. They form a very important part of the financial markets. Such is the importance of brokers in the financial market that one of the most important segment of the market: the Bombay Stock Exchange is actually situated on Dalal Street in Mumbai named after the brokers. (Dalal is a Hindi word for brokers.)
SEBI was now in-charge of registration of brokers. No one could deal in securities without prior approval from the SEBI. The SEBI could, now at will, inspect the books of the brokers as well.
In the 1980s and 1990s, brokers significantly influenced market trends. They could inflate the market and pump up the price of certain stocks with their reputation and knack of the securities market. Brokers often resorted to practices like insider trading in spite of them being unethical. They used information from sources inside the company to evaluate trends of share prices and accordingly decide whether or not to invest. They started manipulating the market and created fictitious demand which disturbed the market equilibrium. At one time in April 1992, the activities of some of the major brokers influenced the market leading to a bullish trend which in turn shot the BSE Sensex to an unprecedented high of 4546.6 points.
The Companies Act, 1956 prohibits insider trading. However, no definition for the same is available in the Act. Section 30 of the Securities and Exchange Board of India Act, 1992 vests the SEBI with powers to make regulations. By this power, the SEBI released the Regulations on Prohibition of Insider Trading in 1992. Section 12A has prohibited insider trading. Section 15G provides for a penalty that can be imposed for any person communicating Unpublished Price Sensitive Information (UPSI) relating to the company to any outsider. The person shall be liable to a penalty not less than 10 lakh rupees and extending up to twenty-five crore rupees or three times the amount of profits made out of insider trading, whichever is higher. The SEBI has regularly amended these regulations in accordance with the needs of the times.
The SEBI was given authority over the stock exchanges as well. In India, there are 9 listed stock exchanges among which Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) are the primary stock exchanges. There are a few regional stock exchanges as well that still function in the economy. The SEBI has the authority to regulate and approve the bylaws of the stock exchanges. This is one of the major functions of the SEBI as stock exchanges are extremely important to the functioning of the market and are in fact the essence of the capital market. They help in the consolidation of the national economy and help in the development of the industrial sector by providing a platform for both investors and business houses. They help in channelizing idle money kept in the form of savings. The stock market has seen a drastic change over the past 2 or 3 decades. Trading in the late 1980s and early 1990s was a long, cumbersome process which caused a lot of delays and left scope for a lot of fraudulent activities. The SEBI brought in a lot of changes in the trading system to overcome these difficulties. The market, which once dealt in shares in the physical form (paper shares), is now completely screen based and dematerialized. The Screen Based Trading System (SBTS) has electronically connected the companies and the investors.
It has helped in reducing the cost and time of trades and has significantly reduced the risk involved in terms of fraud by brokers. Screen Based Trading System has helped to shift the trading platform from a physical place (like the Phiroze Jeejeebhoy Towers that house the BSE in Mumbai) to the broker’s premises to the Personal Computers of the investors in their place of residence or place of work. The expansion of this network has been possible through the internet. It has made a huge difference in the accessibility to the investors spread over the vast geography of this enormous country.
A major transformation that changed the entire scenario of the stock market was the complete dematerialization of shares by the SEBI. Dematerialization or DEMAT for short is the shift from physical certificates of ownership to electronic mode of bookkeeping. Dematerialization in India began in 1996 and it became compulsory for anyone who wanted to trade in securities. Dematerialization was legally enforced by the Depositories Act, 1996. It helped in hassle free transactions. Section 2(1)(e) defines depository as “depository means a company formed and registered under the Companies Act, 1956 (1 of 1956) and which has been granted a certificate of registration under sub-section (1A) of section 12 of the Securities and Exchange Board of India Act, 1992 (15 of 1992)”. Depositories basically act as a custodian for securities. They are an organization or an institution, authorized in this behalf, where securities are stored for safekeeping and to enable easy sale and purchase. In the present times, depositories hold securities electronically and not in the physical form. Depositories provide safety and liquidity in the market. It lends the money kept for safekeeping to other borrowers and thus mobilizes the idle money in the economy.
With dematerialisation, the SEBI also regulated the period of settlement. Earlier, the trading cycle varied from T+14 days for certain securities and T+30 days for other securities. (T refers to the date of transaction). After the trade, settlement took a long time. The cycle was not adhered to as the rules weren’t strictly imposed. Traders often used the term “T+anything” that showed lack of regulation in the transaction. This left scope for many unfair and fraudulent activities to take place. Often, parties revoked the trade promise that led to defaults and risks in settlement. Thus the SEBI initiated to reduce the number of days to settle a trade. It was a gradual transition starting with T+5 days in the introductory phases. By April 2002, this had reduced to T+3 days and then T+2 days in April 2003.
The SEBI also introduced Derivatives in the Indian stock market. Derivatives are instruments that help the market participants to manage their risks in a more efficient way. This was done by hedging, speculation and arbitrage. They were introduced by amending the Securities Contracts (Regulation) Act, 1956 in 1999. Derivatives have gained tremendous importance in the Indian stock markets over the past decade.
The SEBI has continuously put effort in improving market security, efficiency and transparency in dealings to make it investor friendly.
The money market is well regulated by the RBI. Sections 45K, 45L and 45W of the Reserve Bank of India Act, 1934 provide for the regulation of money market instruments. The RBI issues guidelines to regulate the participants of the money market.
Like the capital market, the money market too, plays an important role in the development of the economy and helps in proper utilization of money. Money market instruments act as a close substitute to money and ease the exchange of money in primary and secondary markets.
They help in meeting the short term requirements of both financial and non-financial institutions and the government. Money markets also provide a place for investors to put their surplus funds to safe investing platforms. The returns received in money market are comparatively less than those in capital markets. However, the risk involved in money market transactions is also much lesser.
The RBI is the leader of the money market. It ensures reasonable liquidity of funds in the market. It also regulates the liquidity in banks by altering the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). The RBI also conducts Open Market Operations (OMO), changes bank rates and Repo rates to influence cash availability in the market.
The RBI also regulates inter-bank transactions. This includes inter-bank deposits, inter-bank rates, inter-bank loans and inter-bank securities transactions. Banks only invest in secure, risk-free transactions as they use public money for the transactions. This makes it necessary to have a regulatory body to protect the interest of the depositors.
In the 1980s and 1990s, marketing intermediaries used a few loopholes present in the RBI guidelines to their benefit. The regulations prohibited the banks from transferring funds into the broker’s account. However, the system was slow and the procedures took a long time. To ease the transactions, transferring money in the broker’s account was an accepted market practice. A few brokers along with the bank personnel indulged in this practice with full knowledge of its illegality. This gave rise to a series of frauds that could not be fathomed.
To curb this, the SEBI released a circular SMD/SED/CIR/93/23321 dated November 18, 1993. In the circular, the SEBI provides regulations for transactions among clients and brokers. The SEBI made it compulsory to all member brokers to keep the client money in an account separate from their own.
Banks are not allowed to invest in the capital market over a certain limit as prescribed by the Banking Regulation Act, 1949. Section 19(2) of the Banking Regulation Act, 1949 provides that “no banking company shall hold shares in any company, whether as pledgee, mortgagee or absolute owner, of any amount exceeding 30 percent of the paid –up share capital of that company or 30 percent of its own paid-up share capital”. This is because of the high risk of default in the capital market.
The banks often bought securities of other banks or bought Government securities. Banks could not directly invest in the money market. Here, too, brokers acted as intermediaries. The investor banks transferred the amount to be invested into the broker’s account. The brokers approached the investee bank and sought to get the best deal for the client bank. Once the transaction was completed, the investee bank issued a Bank Receipt as evidence of a securities transaction having taken place. An account of the interbank transactions was maintained in the Securities General Ledger (SGL) and the Public Debt Office (PDO) of the RBI. A few brokers obtained money from the client bank in the name of buying securities from other banks. Then, they created fake Bank Receipts to give to the client bank. They channelized the money received from the client bank into the capital market. With unlimited funds, they could strike up the price of any security they wished to. Once the transaction yielded profit, they returned the money to the bank along with returns. They deceived both the investor banks and investee banks and made profit from these transactions.
Once the RBI noticed these unfair dealings by brokers and banks, it created a special committee called the Janakiraman Committee to investigate the matter. The Committee’s findings shocked the whole system. The frauds by brokers were far bigger than anyone could have imagined. When the news surfaced in the media, the confidence of the public was shaken and the stock market saw an unparalleled fall. For the first time in the history of the market, the BSE had to remain closed for 10 days to ensure correction of the market.
The series of events that happened in the early 1990s had an irreversible effect on the economy of the country. India had just adopted liberalization and was trying to come to terms with the new economic scenario, when it faced a major setback. The series of events exposed the weaknesses present in the legal system and were an eye opener for the law makers. It took several years for various committees to submit their findings on which areas needed improved laws. The committee reports formed the basis for formulation of new laws and amendment of existing laws. The aim of the new laws was to strengthen the financial and the legal system to avoid occurrence of such events in the future. The laws have not one hundred percent succeeded in plugging the loopholes. However, the regulatory bodies are constantly updating the laws to prevent unfair trade practices as much as possible.
Vibha Jain
1st Year
K.L.E Society’s Law College
Bengaluru